Compliance: Existing oil & gas leases may not be what they seem with new technology

The process of extracting energy from rocks in places like Pennsylvania, Texas, Ohio, Indiana, North and South Dakota and Illinois using hydraulic fracturing is capturing a great deal of attention lately — not only in this space, but also in the movies and in the popular press. Fracturing rock is not a new process. Indeed, that is what a drill bit does. High volume hydraulic fracturing in vertical wells is a somewhat newer technology, but it too has been used in the United States as a method of extracting energy from rock for years.

What is new is the process of horizontal drilling, or rather, the conventional process of drilling vertically for several hundred (or thousand) feet below ground surface, and then turning the drill bit ninety degrees and drilling horizontally for several hundred (or thousand) more feet. That vertical then horizontal boring has made it possible, and economically feasible, to extract energy from rock buried deep below the surface of the earth. Because horizontal drilling has made extracting energy from rock feasible and profitable, the process is being employed in more locations and is attracting more and more attention. Illinois recently passed the Illinois Hydraulic Fracturing Regulatory Act, and the process is gaining a lot more attention here.

There has been a great deal of discussion about the safety of the process and of the chemicals used in the high volume, high pressure, subsurface, horizontal practice known as “fracking,” but the purpose of this note is not to argue one way or the other. Everyone can likely agree that the process is heavily industrialized, employs chemicals and heavy power equipment and large volumes of water and sand (often from area natural resources), largely takes place in the subsurface of the earth — beneath aquifers and surface water bodies and in proximity to drinking water wells — and creates a significant waste stream. That is, like all industrialized processes, especially those associated with gathering energy in the form of oil, gas, coal or nuclear, the process can be unsafe. While most will agree with that description, some may not concede that the process can also be made, and shown to be, safe. But, again, the point here is not to argue one or another, but to point out some practical and legal considerations attributable to the new process of horizontal drilling — in this instance, the payment of royalties.

A case decided last month in Texas caught my attention and highlights the new analysis — if not new jurisprudence — associated with horizontal drilling and hydraulic fracturing. In Springer Ranch, Ltd. v. Jones, the court was asked to interpret a royalty payment clause in a lease drafted before the horizontal drilling process was used in an energy producing well. Royalties are money paid to a lessor by the operator/lessee pursuant to an oil & gas lease. The payment formulas in oil & gas leases are as varied as the parties’ imagination, but in this case, the parties agreed in 1993 “that all royalties … from any well … shall be paid to the owner of the surface estate on which such well or wells are situated, without reference to any production unit on which such well or wells are situated….” In this case, with the advancement of the new horizontal drilling technology, the vertical portion of the well was on Springer’s property, but the horizontal boring initiated in the subsurface of Springer’s property and proceeded off Springer’s land and across and into the subsurface of Sullivan’s land. Fortunately both Springer and Sullivan were signatories to the lease under review. Obviously, it would be a different case — one not concerning the interpretation of a lease — if the horizontal portion of the boring had encroached into and captured energy from an adjacent owner not a party to the lease. That topic may be the subject of another note.

Springer argued for the plain meaning of the lease. That is, Springer was entitled to all of the royalties because the well head, “meaning the visible location on the land from which hydrocarbons exited,” was on its land. According to Springer, the plain meaning of the lease provided that the well head was relevant point to determine the right to receive royalty payments, because the lease specifically provided that the royalty rights were to be determined “without reference to any production unit on which such well or wells are located.”

Sullivan argued to the contrary. According to Sullivan, the “productive portions” of the well at issue were actually “situated on” both the Springer land and the Sullivan land, and the royalties should be apportioned according to the relative “productive portions” of the well “situated on” each parties’ property. It is clear that the lease itself only contemplated vertical wells and production from vertical wells.

To reach a determination, the court analyzed various definitions and concluded that a “well” is actually the entire boring, not simply the well head where the hydrocarbons exited. In this case, the “well” was both the vertical and lateral sections of the boring, even though horizontal drilling was not even considered at the time the lease had been drafted. The court also concluded that the word “on” could support both arguments, and therefore, neither parties’ argument concerning the well’s presence was persuasive. According to the court, the word “on” is a “versatile preposition and also denotes other spatial relations, including within the limits or bounds of something.” Finally, the court interpreted the term “surface estate” to be “that portion of the earth, over which the surface estate owner holds dominion after a severance of the mineral interest.” That is, the “surface estate” is “every right in real property other than the mineral interest.

In the final analysis, the court agreed with Sullivan and apportioned the royalties according to the relative portions of the producing boring under each parties “surface estate.” The vertical portion of the well boring was not in active production, and the court did not attribute any royalties to that portion of the well, and accounted only for the producing portion of the horizontal boring — some of which was on Springer’s property, but most of which was beneath Sullivan’s “surface estate.”

With hydraulic fracturing on the horizon in your area, perhaps lawyers should review existing oil and gas leases to determine if the royalty payment provision in the existing leases describes what is intended in 2014.